Should Italy leave the eurozone?

Abstract

▀ Italy's post‐financial crisis performance has been dismal, with the economy only some 2% larger in per capita terms than when the country adopted the euro in 1999. On that basis, Italy's membership of the single currency might appear to be a mistake. But the prospect of leaving the eurozone to regain monetary and fiscal control is, in our view, largely a mirage. Not only is there little evidence to suggest that Italy was better off before it joined the euro, but the real causes of the economy's malaise are bound up with poor productivity growth and high debt, neither of which would be addressed by leaving the euro. ▀ The pervasive sense of Italy's stagnation since 2008 undoubtedly contributed to this year's election results, which led to the formation of the Five Star Movement‐Lega populist coalition government. In the past, the two parties have partly blamed the country's economic problems on its eurozone membership. While it is true that Italy's nominal adjustment within the single‐currency area since the financial crisis has been painfully slow, we do not think leaving the eurozone would help this process. ▀ Rejecting the euro would impose very significant costs on the economy and financial system. Capital controls would be needed to prevent deposit flight, while the depreciation of a new lira would lead to a sharp increase in inflation that would erode any improvements in competitiveness. Moreover, a post‐exit depreciation would reduce the potential gain from any write‐down of external debt, leaving debt as a share of GDP largely unchanged. The return of sovereign and currency risk premia would also significantly raise long‐term interest rates. ▀ For the past two decades, the economy has been unable to reallocate capital and labour to more productive uses, as exemplified by the high level of non‐performing loans and low productivity growth. Regaining domestic control over monetary and fiscal policy will not solve this problem, despite the easy political capital to be had by continuing to blame EU institutions and Italy's euro membership for it.